Abstract

http://ssrn.com/abstract=1787478
 
 

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Bond Variance Risk Premiums


Hoyong Choi


London School of Economics & Political Science (LSE)

Philippe Mueller


London School of Economics & Political Science (LSE) - Department of Finance

Andrea Vedolin


London School of Economics and Political Science

May 31, 2015


Abstract:     
This paper studies variance risk premiums in the Treasury market. We first develop a theory to price variance swaps and show that the realized variance can be perfectly replicated by a static position in Treasury futures options and a dynamic position in the underlying. Pricing and hedging is robust even if the underlying jumps. Using a large options panel data set on Treasury futures with different tenors, we report the following findings: First, the term-structure of implied variances is downward sloping across maturities and increases in tenors. Moreover, the slope of the term structure is strongly linked to economic activity. Second, returns to the Treasury variance swap are negative and economically large. Shorting a variance swap produces an annualized Sharpe ratio of almost two and the associated returns cannot be explained by standard risk factors. Moreover, the returns remain highly statistically significant even when accounting for transaction costs and margin requirements.

Number of Pages in PDF File: 54

Keywords: Variance risk premium, Treasury implied volatility, Treasury variance swap

JEL Classification: E43, G12


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Date posted: January 2, 2012 ; Last revised: June 4, 2015

Suggested Citation

Choi, Hoyong and Mueller, Philippe and Vedolin, Andrea, Bond Variance Risk Premiums (May 31, 2015). Available at SSRN: http://ssrn.com/abstract=1787478 or http://dx.doi.org/10.2139/ssrn.1787478

Contact Information

Hoyong Choi
London School of Economics & Political Science (LSE) ( email )
Houghton Street
London, WC2A 2AE
United Kingdom
Philippe Mueller (Contact Author)
London School of Economics & Political Science (LSE) - Department of Finance ( email )
Houghton Street
London, WC2A 2AE
United Kingdom
Andrea Vedolin
London School of Economics and Political Science ( email )
Department of Finance
Houghton Street
London, WC2A 2AE
United Kingdom
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